Concept of Interest
Interest is a financial transaction in which a borrower is obligated to pay an additional amount to a lender in return for borrowing a certain amount of money (principal). This extra money is called “Interest”. Basically interest rate is fixed as per the contract. The process of charging interest on debt applies to a variety of cases, from personal loans to business loans, home or car loans, and other financial transactions.
Key Features of Interest on Loans
Principal: This is the main fund or amount of money that the borrower borrows from the lender. Interest is calculated on this principal.
Interest Rate: Interest rate is the amount charged on the principal of loan. The interest rate is expressed as a percentage of the total loan amount. It can be yearly, monthly, bi-monthly or daily.
Loan Tenure: This is the period for which the loan is to be repaid. The longer the tenure, the higher the interest on the loan, especially if it is compound interest.
Repayment Plan: Loan repayment along with interest is done through a fixed plan. It can be monthly, quarterly or other frequency.
Types of Interest on Loans:
- Fixed Interest:
In this case the interest rate remains unchanged for the entire term of the loan. The borrower knows at the outset how much interest he has to pay. This is advantageous for the borrower as he will pay fixed interest even if the interest rate rises. - Variable Interest:
In this case the interest rate varies over time based on market conditions. If the interest rate increases, the borrower’s interest also increases, and if the interest rate decreases, it decreases. - Simple Interest:
Simple interest is determined based on the principal only. Here a fixed amount of interest is charged according to the tenure of the loan. - Compound Interest:
Compound interest charges interest on capital as well as previously earned interest. That is, in each period the interest of the previous period is added to the capital and interest is calculated afresh. This can be relatively costly for the borrower.
Economic Impact of Interest on Loans:
Interest increases the value of the loan. The borrower not only repays the principal, but also pays additional interest along with it. It is an important factor for the economy as interest drives financing and serves as a source of income for lenders.
Stress on the borrower: Interest on the loan becomes an additional cost to the borrower, which can cause financial stress on him, especially if the interest rate is high.
Profit for Lenders: Lenders get a return on their capital through interest, which protects their capital and provides an incentive for further investment.
Economic Stability: Interest rates maintain financial balance between borrowers and lenders. Central banks control interest rates to maintain inflation, economic growth and market stability.
Advantages and disadvantages of interest on loans:
Benefits:
i) A stable source of income for borrowers.
ii) Emergency financial assistance for borrowers.
iii) Encourages investment and savings.
Problem:
i) High interest rates can put financial pressure on borrowers.
ii) With compound interest, the loan amount increases rapidly for the borrower.
iii) Religious and ethical challenges.
Operating economic activities based on interest is very important in business and personal financial decisions. However, it is important to follow the right amount and policy in its use, so that the benefits are maintained for both borrowers and lenders.
More Resources
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